Managing and Identifying Risk Spring 2008 All of life is te management of risk, not its elimination Risk is te volatility of unexpected outcomes. In te context of financial risk it can relate to volatility in i) te value of a firm s assets and liabilities as well as ii) te prices of inputs and outputs. Firms need to decide wic risks to accept and wic to manage. Tey need to concentrate on ow tis relates to implementing teir business strategy and improving teir competitive position. Wat Are te Risks Faced by Firms? Risk management requires tat risk exposures are identified, measured and controlled. 1. Business risk manufacturing and marketing its products to create a competitive advantage How does tis risk depend on our actions? Oters actions? Is tis someting we sould try to edge? 2. Financial risk sensitivity of casflows to movements in financial markets (e.g. interest rates, excange rates, commodity prices, ) How do tese impact our profitability? Our competitive position domestically? in foreign markets? Is tis someting we sould try to edge?
Financial Risk Specific types of financial risk: Market risks (canges in financial prices) Credit risks (counterparty risk) Liquidity risks (ability to buy/sell) Operational risks (management decisions) Legal risks, reputation risks Financial risk management is te process of creating economic value by using financial tools or operational decisions to manage exposure to te risks associated wit canges in tese financial variables. Examples of Financial Risks Major types of market risk: Interest rate risk Excange rate risk Equity risk Commodity risk US AAA Interest Rates (annual yield) 12 10 8 6 4 2 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
US Gas Prices (US cents per gallon) 350 300 250 200 150 100 50 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Dow Jones Industrial Average 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Canadian US dollar (C$ / US$) 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 1990 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2001 2002 2003 2004 2005 2006 2007
Factors Influencing Risk Management Modern risk management considers te following: Accounting Rules Mkt Prices Risk Mgmt F/S Info Economic Costs Steps in Risk Management Identify key factors wic impact firm profitability Large, diversified firms likely ave less exposure to foreign excange risk Assess volatility/uncertainty of prices in financial markets using istorical data. Develop pro-forma models of te impact on earnings and sareolder value of canges in financial factors (e.g. sensitivity or scenario analysis). Set corporate policies on acceptable levels of earnings and sareolder value at risk. Set procedures for monitoring and managing risk. Identifying Risk Te tree main types of foreign excange risk: Transaction Exposure Gain or loss on a contracted transaction resulting from a cange in excange rates. Translation or Accounting Exposure Effects of canges in excange rates on te translation back of assets and liabilities denoted in foreign currencies into te domestic currency denominated financial statements. Economic or Operating Exposure Canges in te value of a firm induced by canges in demand for its products or supply of its production factors caused by canges in excange rates.
Example of Transaction Risk A US electronics company contracted to sell 100,000 semiconductors to a Frenc computer manufacturer for a price of 10Euro / piece. Delivery is in 90 days wit payment upon delivery. If te excange rate was $1.32/EUR wen te contract was signed te US firm expects to get $1,320,000 from tis sale. If te excange rate canges to $1.25/EUR, te US firm will only get $1,250,000. Te possible cange in revenues is transaction risk. Example of Translation Risk If our US electronics company decided to set up a Frenc subsidiary to do tis and future transactions, consider ow excange rate canges would impact its balance seet if it started as follows: Assets Liabilities. Cas 50M EUR Current Liabilities 350M EUR Inventory 300M EUR Long-Term Debt 50M EUR Plant & Equip 100M EUR Equity 50M EUR Total 450M EUR Total 450M EUR Wat is te most important item ere to te US parent? Example of Translation Risk cont d If te initial excange rate was $1.10/EUR, te translated values of te subsidiary would be: Assets Liabilities. Cas $55M Current Liabilities $385M Inventory $330M Long-Term Debt $55M Plant & Equip $110M Equity $55M Total $495M Total $495M Wat would appen to te value of te subsidiary for te parent if te excange rate went to $1.05/Euro? Would te parent care?
Example of Translation Risk cont d If te excange rate went to $1.00/Euro, te translated values of te subsidiary would be: Assets Liabilities. Cas $50M Current Liabilities $350M Inventory $300M Long-Term Debt $50M Plant & Equip $100M Equity $50M Total $450M Total $450M Altoug te Euro values are uncanged, te US dollar value of te equity as fallen. Is tis a problem? Example of Economic Risk Tere are two components: Future exposure: te impact of unexpected excange rate canges on te value of future income denominated in different currencies. If our contract as us getting paid over te next 20 years, ow will excange rate canges impact te PV of our future casflows? Competitive exposure: te impact of excange rate canges on te ability of a firm to compete based on teir impact on te costs and revenues for te firm and its competitors. Wen te yen was low in value, Japanese imports flooded te markets in Nort America. Te Hedging Decision Wy not? Sareolders can diversify away risks temselves. Tere is no need for te firm to do tis for tem (M&M Proposition I) Costly to edge and it does not increase expected casflows, so wy incur te cost? Managers can not outguess te market, so in equilibrium (on average) te expected value of edging is zero. Managers may edge to increase teir job security, but not to maximize firm value. Hedging is irrelevant, since it can not decrease a firm s systematic risk and tat is all investors care about.
Te Hedging Decision (cont d) Wy? Management knows more about te firm s risk profile, so it can edge its risks better tan sareolders. Decreases te risk of bankruptcy For a given amount of outstanding debt, edging reduces te probability of bankruptcy. Te treat of financial distress can be very ig, bot directly and indirectly. Smootes earnings - stock markets like tis! Firms may ave to forego positive NPV projects because tey cannot raise capital or accurately predict teir casflows. Managing Transaction Risks A transaction exposure is created as soon as te seller quotes a price in foreign currency terms and exists until te buyer settles te bill. Recall our example: a U.S. company expects to receive 1 million in tree monts. Wat could te U.S. company do to manage tis risk? Alternatives for managing transaction risk: Remain unedged Use forwards/futures Use a money market edge Use options Managing Transaction Risks Remaining unedged means tat we ave decided to accept te transaction risk. We get all of te benefit and suffer all of te costs of canges in te excange rate. Forward/futures: we agree to excange currencies at a stated rate at a given future date. Wat appens if te contract is not awarded if we use forwards? futures? Wat does te Expectations Teory tell us about te expected value of tis strategy?
Managing Transaction Risks Money Market Hedge: we borrow in te foreign currency, excange tat for our domestic currency at te spot rate. Wen we get paid te foreign currency we pay back te loan and interest wit te proceeds. Te costs will be similar to tose of a forward. Te final cost will depend on te interest rate differential and ow we invest te domestic currency obtained after converting te loan. Bot te Money Market Hedge and te Forward contract totally remove te risk of future excange rate movements. We get a known amount in te future. Managing Transaction Risks Options: we can purcase a put option on te foreign currency so tat we can lock in a minimum price at wic we can sell te proceeds from our transaction. Wat appens if te foreign currency appreciates versus our ome currency? Depreciates? Wat appens if we do not get te contract? Unlike te two previous alternatives, tis is not riskless. Tere is a ig cost, but also te possibility for gains if te excange rate moves in te rigt direction, and a floor for te losses if it does not. Summary: Managing Transaction Risks For our transaction risk example: Unedged do noting Forward/future buy a forward/future to sell 1,000,000 Euros for 1.30 USD/EUR in 90 days Money Market borrow 990,099 Euros today at 4%, convert to USD, and invest in US. Owe 1,000,000 Euros in 90 days Option buy a put on Euros to sell 1,000,000 Euros at a strike price of 1.30 USD/EUR in 90 days (wy not 1.25 USD/EUR?). How to decide wic to use? Cost of eac alternative? Risk tolerance of firm? Corporate policy for exposure to transaction risk?
Managing Translation Risks Accounting exposure arises wen te financial statements of foreign affiliates (stated in foreign currency) must be restated in te parent company s currency for te preparation of consolidated financial statements. Te translation of te foreign affiliates assets and liabilities (and possibly derivatives) may result in an increase or decrease in te parent company s net wort and reported net income due to canges in te excange rate since te last report. Main alternative: Balance Seet edge Managing Translation Risks Balance Seet Hedge: te firm maintains an equal amount of foreign currency assets and liabilities on its balance seet to remove te net exposure. Ways to do tis: 1. Convert all existing cas into te parent company s domestic currency immediately. Tis decreases te quantity of assets witout influencing te value of te liabilities. 2. Delay te repayment of debt and convert te cas tat would ave been used for tis to te domestic currency. 3. Forward or Money Market edges: if te parent firm as a net asset (liability) exposure in te foreign currency, get an equal sized liability (asset) in te foreign currency to offset it. Summary: Managing Translation Risks For our example we could: Pay out te 50M Euros from cas and convert to USD. Tis would remove te value of equity from te balance seet and leave zero net exposure. Parent firm could sell a forward for 50M Euros, or borrow 50M Euros to ave a liability on its balance seet to offset te 50M Euro asset (equity) from te foreign affiliate.
Managing Operating Risks Tey are long-term risks related to many unknown events for te firm and its competitors. Some alternatives to edge operating risks: Matcing currency casflows: offset a continuous stream of future foreign income wit foreign debt requiring a corresponding set of payments. Tis is similar to a series of forwards financing domestic debt. Credit Market Swaps: two firms in different countries borrow longterm in teir ome country and make te payments for te oter company (swap) using teir stream of foreign income. Tis keeps te liabilities on te firms books in teir ome currency. Diversify operations across countries. Summary: Managing Operating Risks We ave 100M Yen casflows guaranteed every year for te next 10 years. Matcing currency casflows: borrow Yen for 10 years today. Every year make 100M Yen payments. Tis could be set up so te 100M Yen includes bot interest and principal. Tis is similar to a series of forward contracts to sell 100M Yen every year for 10 years. Credit Market Swap: borrow US dollars for 10 years and swap tis wit a Japanese firm aving borrowed Yen for 10 years. We make teir 100M Yen interest payments and tey make our USD interest payments. Tis keeps te liabilities on te firms books in teir ome currency. Diversify operations across countries so casflows are not all in Yen. Wo is Hedging Currency Risk? Survey of currency derivative use by firm size. Te sample was 372 large U.S. firms for fiscal year end 1991 tat ad foreign excange rate exposure as of fiscal year-end 1990. Companies are among te 500 largest (by sales) companies in te Fortune 500: 4t Quartile (largest firms) 75.3% 3rd Quartile 38.7% 2nd Quartile 34.3% 1st Quartile (smallest firms) 17.2% Source; C. Geczi, B. Minton and C. Scrand Wy Firms Use Derivatives, Te Journal of Finance, September 1997.
Use of Derivatives in Hedging FX Risk Type of Instrument Frequency of Use Forward Contracts 72.3% Over-te-Counter Currency Options 18.8% Excange Traded Currency Options 5.4% Currency Futures Contracts 4.1% Source: K. Jesswein, C. Kwok and W. Folks Wat New Currency Risk Products are Companies Using and Wy?, Journal of Applied Corporate Finance, Fall 1995.